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Chapter 4
Consumer and Firm Behavior:
The Work-Leisure Decision and Profit
Maximization
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 1
Plan



Understanding basic microeconomic
principles to build a simple macroeconomic
model.
One period model i.e., STATIC Decisions.
NO SAVINGS.
Many periods model i.e., DYNAMIC
Decisions. PART III.
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 2
Consumer Optimization Problem

One decision to make:
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

How many units to eat (consume)?
How much time for leisure?
The consumer supply labor and demand
goods.
Work-Leisure decision is affected by:


Preferences
Constraints
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 3
Firm Optimization Problem


How much labor to hire/fire ?
The decision to maximize profit depends on:
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

available technology
market environment
The firm demands labor and supply goods.
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 4
Macro Outcome
Given the optimizing behavior of:
The consumer
The firm
Analyze how these economic agents will respond
to changes in the environment they live in.
For example:
a change in taxes
a change in the wage rate
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 5
The Representative Consumer (all are identical)

Preferences
Budget constraint
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Optimize (find best rational choice, rational)
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How to respond to a change in:
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

Non-wage income
Market wage rate
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Slide 6
Figure 4-1 Indifference Curves (Preferences)
U(Consumption,leisure)
Indifferent between
B and D
A is preferred to B
Levels of
Happiness
A B
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Slide 7
Figure 4-1 Indifference Curves (Preferences)
More is better
I 2  I1
3 Assumptions
1) More is better
Convex to origin
(like diversity)
2) Like diversity
3) C and l are normal
goods (both increase when income increases)
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 8
Moving along an Indifference Curve
Moving from B to D, the consumer
Substitute consumption by leisure
Substitute leisure for consumption
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Slide 9
Figure 4-2 Properties of Indifference Curves
Marginal Rate of Substitution
(MRSl,c) = - Ul / Uc =  c /  l
Convex to origin
Diminishing MRS
Explain
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 10
Budget Constraint



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No money Economy (Barter Economy).
Two goods: consumption and labor time.
Any trade must involve the exchange of goods
for labor time.
Time constraint: l + Ns = h  Ns = h - l
Leisure time l + Work time Ns = Total time available

Budget constraint: C = w Ns +  - T
real consumption = real disposable income
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 11
Breakdown of the Budget Constraint
Budget constraint
C = w Ns +  - T
 w : real wage
 w Ns : real wage income in units of goods
  : (real profits) real dividends from firms.
The consumer owns the firm

T : real lump-sum taxes (does not depend on
the actions of the agent being taxed).
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 12
Real Expenditure and Real Disposable Income
C = w Ns +  - T
Substitute Ns = h – l into the budget
C = w (h – l)+  - T
Then multiply w by the parenthesis
C = wh – wl +  - T
Rearrange to get
C + wl = wh +  - T
W is the price of leisure in terms of the cons’ good.
C + wl : the implicit real expenditure on c and l
wh +  - T : the implicit real disposable income
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 13
Figure 4-3 Representative Consumer’s Budget
Constraint (T > )
Vertical Intercept
l=0C=wh+-T
Solve for Point B
Slope: - w
HH behaves competitively i.e.,
price-taker (actions have no
effect on the prices).
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
-T <0
Slide 14
Figure 4-4 Representative Consumer’s Budget
Constraint (T < )
h=l
Slope: - w
Can’t take
leisure more
than h hours
h=lC = -T
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 15
Figure 4-5 Consumer Optimization
OPTIMAL CHOICE
Slope of U = Slope of Budget
will never choose J
because more is
better
Explain why point F is
not the optimal choice?
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Slide 16
The Optimal Choice and the Slopes
MRSl,c > w
MRSl,c = w
EXPLAIN
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Slide 17
Figure 4-6 The Representative Consumer
Chooses not to Work
Corner Solution will not
happen; WHY?
Simply, because the
consumer has preference
for BOTH cons’ and leisure
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 18
The Game
Starting from an (equilibrium) optimal choice
how does the consumer respond to changes in:

Real Dividend Income minus Taxes


Example: tax cut
Real Wage
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 19
Figure 4-7 An Increase in the Consumer’s
Dividend Income
Tax Cut
C
WHY HERE?
Why not there
New Equilibrium
 Leisure
Old Equilibrium
Pure Income Effect
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 20
Figure 4-8 Increase in the real Wage Rate
Income and Substitution Effects
W increases  consumer FOH
FO : Substitution Effect
OH : Income Effect
Substitute away
from the
expensive good:
leisure
As w increases, the budget rotates
upward: EB is steeper than AB
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 21
Effect of Real Wage on Labor Supply
FO : Substitution Effect  Increases Ns i.e.,
Reduces Leisure
OH : Income Effect  Decreases Ns i.e.,
Increases Leisure
Assume that this
one dominates
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 22
Figure 4-9 Labor Supply Curve
Labor Supply is
upward sloping by
assuming that the
Substitution Effect
dominates the
Income Effect
True at low levels of real wage
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Slide 23
Figure 4-10 Effect of an Increase in Dividend
Income or a Decrease in Taxes
Why?
Look at Slide 20
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Slide 24
THEORY CONFRONTS DATA
Empirical Evidence
Figure 4-12 Real Wage in Manufacturing,
1947-1998
Average Wage / CPI
Trend
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Slide 26
Figure 4-13 Average Hours per Week in
Manufacturing, 1947-1998
No Trend
Ns
Income = Substitution
Upward Trend
Large Income Effect
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 27
The Representative Firm
The Representative Firm

Choices:
 Supply consumption goods
 Demand labor

Choices determined by:
 Available technology  Production
Function
 Profit maximization
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 29
The Production Function
K:
N:
z:
Y = z F( K, Nd )
Capital input
Labor input
Total Factor Productivity:
Degree of sophistication of the
production process
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 30
Figure 4-14 Production Function, Fixing the Quantity of
Capital and Varying the Quantity of Labor
Y = z F(K,Nd)
Marginal
Product of Labor
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 31
Figure 4-15 Production Function, Fixing the Quantity of
Labor and Varying the Quantity of Capital
Marginal Product
of Capital
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Slide 32
Properties of the Production Function
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Constant Returns to Scale
Marginal product is positive
Diminishing marginal product (concavity of
the production function)
Marginal product shifts whenever the
quantity of the other factor input change
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 33
Implications of the Returns to Scale
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Constant Returns to Scale: (CRS)
a small firm is just as efficient as a large
firm.
Increasing Returns to Scale: (IRS)
large firms are more efficient than
small firms.
Decreasing Returns to Scale: (IRS)
small firms are more efficient than
large firms.
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 34
Implication of CRS
The economy will behave in exactly the
same way if there were many small firms
producing consumption goods as it would if
there were a few large firms, provided that
all firms are price-takers.
CRS allows us to select a representative
firm.
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 35
Figure 4-16 Marginal Product of Labor Schedule
for the Representative Firm
The Slope of the
production function,
holding K fixed.
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Slide 36
Figure 4-17 Adding Capital Increases the
Marginal Product of Labor
K increases 
MPN shifts upward
EXPLAIN WHY
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Slide 37
Figure 4-18 Total Factor Productivity Increases
z reflects proportional
change to the
production function
Shifts MPN
Can you graph a parallel
versus a proportional shift?
What are the effects on MPN?
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Ex: Technological Innovations
Slide 38
Figure 4-19 Effect of an Increase in Total Factor
Productivity on the Marginal Product of Labor
Z
implies
MPN
WHY?
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 39
Reasons for Changes to Total Factor Productivity




Technological Innovations
Weather
Government Regulations (e.g., installation
of pollution abatement equipment)
Relative Energy Prices
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 40
Measuring Total Factor Productivity
Y = z F( K, Nd ) = z K N1-
z is computed as a residual
The Solow residual (after Robert Solow 1957)
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 41
Figure 4-20 The Solow Residual for the
United States
Y
z  0.36 d 0.64
K (N )
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 42
Profit Maximization
Figure 4-21 Revenue, Variable Costs,
and Profit Maximization
Slopes are equal
MPN = w
Slope = MPN
Slope = w
Profits = Revenues - Costs
d
  zF ( K , N )  wN
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
d
Slide 44
Figure 4-22 The Marginal Product of Labor Curve Is the
Labor Demand Curve of the Profit-Maximizing Firm
For a given w, MPN tells us how many
to hire (to maximize profits).
w
Copyright © 2002 by O. Mikhail , Graphs are © by Pearson Education, Inc.
Slide 45